Oil Market Report September, 2016

Oil traders love to speculate. Not always the kind of market speculation that the media like to talk about, but speculation in the literal sense of the word. They speculate on whether oil demand will continue to increase, whether it will be a cold winter, what the impacts of Brexit will be and so on. More than anything else however, oil traders like to speculate on the activities of OPEC and with not a great deal actually happening on the oil markets in September (prices remaining fairly stable around the $45 per barrel mark), speculation around OPEC’s intentions hit fever pitch.

The process started at the beginning of the month when an Informal” OPEC meeting in Paris became the centre of a rumour that a production output freeze was imminent. Prices promptly headed sharply northwards, but soon ran out of steam when the official post-meeting announcements were made. So vague were they (OPEC will make a firm commitment…to agree…on something definitely being done…at some point in the future…) that it was clear that assertive action was not imminent. So prices tumbled back down and fell to a lower level than before the rally started.

But speculation rarely tends to be 100% baseless and with another Informal” OPEC meeting (this time including Russia) scheduled for 28th September in Algiers, the consensus opinion is that a decisive OPEC move on production is now highly likely. The ongoing backdrop of course is the continued low oil price and the devastating effect this is having on OPEC members. State budgets have been blown and blown again in an organisation where between $75 per barrel (Saudi Arabia) and $150 per barrel (Venezuela) is required to balance the books.

At an average production cost of $15 – $20, such anxiety amongst OPEC members is surely misplaced? The likes of Saudi Arabia, Iran and Venezuela have some of the lowest operating costs anywhere in the world and even at $50 per barrel, profits should be handsome. But the new Millennium saw massive public spending programmes in OPEC countries and even with the riches of oil at $100+ per barrel, these projects were soon creating large fiscal imbalances. At $50 per barrel, we have fiscal melt-down! Even Saudi Arabia – the wealthiest OPEC member by far – seems to be wobbling. Analysts believe that the Middle Eastern Kingdom has dipped into its sovereign wealth fund to the tune of $350bn (of a $750bn total) and for the first time in its history, the Saudis have gone to the Bond Market to raise further funds.

That OPEC members desperately desire oil prices to rise then, is a fairly safe conclusion to make. But what exactly can OPEC do to deal with low prices that a) does not upset the rest of the world and b) will be effective? Clearly a full-on reduction in output would almost certainly drive prices upwards. But this would significantly upset the Western (and Eastern) consuming nations, who OPEC still need to keep on side for reasons outside of oil. Then there is the small matter of Iran, who are determined to build up production to pre-sanction levels. They would certainly not agree to a reduction and nor would Libya, Nigeria, Venezuela and Iraq – all of whom have recently experienced production drops. It would be highly unlikely that these members would see further supply reductions as the solution to their own problems – after all it is a counter-intuitive move for bankrupt countries to reduce the output of the one thing that brings in revenue.

The other option is the much talked about output freeze. In the short-term, such a move (so long as it was officially agreed, rather than just talked about officially) would probably push prices into the $50 – $60 range. But after that? An output freeze would only prevent the world supply glut increasing in size and would do nothing to fundamentally address the overall supply versus demand imbalance. Moreover don’t forget (as if you would!), the ever looming shadow of shale oil. Faced with tumbling oil prices, this part of the industry has reacted impressively with labour and rig-rental costs being dramatically reduced. The result is that overheads for US shale operations are down by an incredible 65% since 2014 and with no public infrastructure projects to worry about(!), many shale oilers are still making a pretty decent living at $50 per barrel. If the OPEC production freeze was to become a reality, wouldn’t this just be the green light for even more shale oilers to come back into the market?

This of course was what the Saudi’s always feared and why they have hitherto steadfastly refused to tinker with OPEC production levels. Why curtail your output when the “cowboys” in the USA are poised and ready to steal your market share? However, two years of eye-watering losses” will have focused minds and perhaps the Saudis now begrudgingly accept that whatever they do, the shale oilers are here to stay. In this light, we should see the output freeze as a way of pushing prices up to the $50-$60 price range in the short-term. This will at least give creaking OPEC budgets a bit of breathing space and of course would allow the cartel to start talking about the next price band of $60-$70. If the shale oilers are here to stay, then talking the market upwards and trying to legitimise higher prices is pretty much all OPEC can do…